Markets seem to be missing the risks on US inflation

The Fed will eventually have to do more than ‘budge’ on interest rates

Rebecca Patterson

Fed chair Jay Powell prefers to wait for pandemic-related distortions to subside before judging whether inflationary pressures are persistent © Bloomberg

The US economy today is about as strong as it has been in generations, with the tightest labour markets and highest inflation rates seen in decades. 

That is even accounting for a recent moderation of growth driven by the spread of the Delta variant of Covid-19, reflected in Friday’s disappointing August jobs data.

Yet financial markets continue pricing in both that the inflation will prove transitory and that policymakers will barely need to budge in response. 

We see this potential combination of outcomes as unlikely.

Let’s first consider the outlook for inflation — persistent or transitory? 

We certainly would not expect the record-high consumer price prints from earlier this year to be sustained.

But aggressive fiscal stimulus (including another $2-3tn in spending likely to be passed before year-end), accommodated by money printing, is fuelling demand without commensurate supply.

Households are flush with cash with high levels of wealth and benefiting from low borrowing costs. 

They are spending, including on housing at a time when supplies are very limited and unlikely to materially improve soon.

That broad, strong consumer backdrop is also resulting in companies needing to hire — with job openings outstripping the number of job seekers and pushing up wages in a way we similarly think could be sustained and feed into a self-reinforcing economic recovery. 

Not surprisingly, the reflationary trends we have seen in recent quarters has led to an increase in expected monetary tightening, with two 0.25 percentage point rises now discounted over the coming two years and asset purchases expected to be wound down by the start of 2023.

But the shift in expected tightening is modest relative to any previous cycle and remains extraordinarily easy compared with the strength of the US economy. 

At the same time, the inflation break-even curve is charting a path back to normality within just a few years, and both nominal and real rates are near secular lows.

Ultimately, the Fed will react to economic conditions, which gets us to the second part of this market vision of the future. 

Will the policy-setting Federal Open Market Committee “barely need to budge”? 

There’s no question that central bankers are unusually challenged to read the economic tea leaves amid a pandemic. 

This difficulty at the Fed is evident in the increasingly vocal debate around how to interpret labour-market and inflation conditions.

Minutes from the July FOMC meeting highlighted, for instance, that employment remained well below its pre-pandemic level, reflecting elevated unemployment and people dropping out of the labour force. 

At the same time, though, it noted firms reportedly struggling to hire workers, and thus raising wages or providing additional incentives to attract or retain workers.

With both labour and inflation, the Fed is wrestling with the degree to which supply shortages reflect pandemic-related disruptions that can be easily resolved, and where conditions will settle when pandemic influences fade.

In recent weeks, several Fed officials have suggested that they may need to start the tightening cycle sooner and potentially at a faster pace than is currently discounted. 

For now, this is a minority view.

More dovish members, including the majority of today’s FOMC voters and chair Jay Powell, would prefer to wait for pandemic-related distortions to subside before judging whether inflationary pressures are persistent and whether labour markets are consistent with the Fed’s goal of eliminating “shortfalls”

These conversations are happening in the context of lessons learnt from the last few decades. 

Keeping monetary policy too tight and not being able to ease enough is seen as a bigger risk than allowing inflation to rise and needing to tighten and catch up later. 

With the Fed’s newfound commitment to allow inflation to overshoot 2 per cent, the more dovish perspectives are carrying the day for now.

Given the Fed’s goal to prevent low inflation or deflation from becoming entrenched, as it has in Japan and to a degree in Europe, we empathise and agree with the shift toward easier policy. 

We also do not envy how the Fed will have to balance the difficult trade-off between growth and inflation risks.

The Fed’s deliberations (and the composition of who actually votes and chair Powell’s inclinations) for now point toward slower tightening. 

We expect the Fed will still have to eventually do more than “budge” on rates.

More immediately, though, we think market pricing, data trends and the Fed’s evolving reaction function underscore a very real need for investors to protect portfolios against higher, more sustained inflation.

The writer is director of investment research at Bridgewater Associates. 

Connecting the Dots in China

The new dual thrust of Chinese policy – redistribution plus re-regulation – will subdue the entrepreneurial activity that has been so important in powering China’s dynamic private sector. Without animal spirits, the case for indigenous innovation is in tatters.

Stephen S. Roach

NEW HAVEN – All eyes are fixed on the dark side of China. 

We have been here before. 

Starting with the Asian financial crisis of the late 1990s and continuing through the dot-com recession of the early 2000s and the global financial crisis of 2008-09, China was invariably portrayed as the next to fall. 

Yet time and again, the Chinese economy defied gloomy predictions with a resilience that took most observers by surprise.

Count me among the few who were not surprised that past alarms turned out to be false. But count me in when it comes to sensing that this time feels different.

Contrary to most, however, I do not think Evergrande Group is the problem, or even the catalytic tipping point. 

Yes, China’s second-largest property developer is in potentially fatal trouble. 

And yes, its debt overhang of some $300 billion poses broader risks to the Chinese financial system, with potential knock-on effects in global markets. 

But the magnitude of those ripple effects is likely to be far less than those who loudly proclaim that Evergrande is China’s Lehman Brothers, suggesting that another “Minsky Moment” may well be at hand.

Three considerations argue to the contrary. 

First, the Chinese government has ample resources to backstop Evergrande loan defaults and ring-fence potential spillovers to other assets and markets. 

With some $7.5 trillion in domestic saving and another $3 trillion in foreign exchange reserves, China has more than enough capacity to absorb a worst-case Evergrande implosion; recent large liquidity injections by the People’s Bank of China underscore the point.

Second, Evergrande is not a classic “black swan” crisis, but rather a conscious and deliberate consequence of Chinese policy aimed at deleveraging, de-risking, and preserving financial stability. 

In particular, China has made good progress reducing shadow banking activity in recent years, thereby limiting the potential for deleveraging contagion to infect other segments of its financial markets. 

Unlike Lehman and its devastating collateral damage, the Evergrande problem hasn’t blindsided Chinese policymakers. 

Third, risks to the real economy, which has entered a temporary soft patch, are limited. 

The demand side of the Chinese property market is well supported by the ongoing migration of rural workers to cities. 

This is very different from the collapse of speculative housing bubbles in other countries, like Japan and the United States, where supply overhangs were unsupported by demand. 

While the urban share of the Chinese population has now risen slightly above 60%, there is still plenty of upside until it reaches the 80-85% threshold typical of more advanced economies. 

Notwithstanding recent accounts of shrinking cities – reminiscent of earlier false alarms over a profusion of ghost cities – underlying demand for urban shelter remains firm, limiting downside risks to the overall economy, even in the face of an Evergrande failure.

China’s most serious problems are less about Evergrande and more about a major rethinking of its growth model. 

Initially, I worried about a regulatory clampdown, writing in late July that the new measures took dead aim at China’s internet platform companies, threatening to stifle the “animal spirits” in some of the economy’s most dynamic sectors, such as fintech, video gaming, online music, ridesharing, private tutoring, and takeaway, delivery, and lifestyle services.

That was then. 

Now, the Chinese government has doubled down, with President Xi Jinping throwing the full force of his power into a “common prosperity” campaign aimed at addressing inequalities of income and wealth. 

Moreover, the regulatory net has been broadened, not just to ban cryptocurrencies, but also to become an instrument of social engineering, with the government adding e-cigarettes, business drinking, and celebrity fan culture to its ever-lengthening list of bad social habits.

All this only compounds the concerns I raised two months ago. 

The new dual thrust of Chinese policy – redistribution plus re-regulation – strikes at the heart of the market-based “reform and opening up” that have underpinned China’s growth miracle since the days of Deng Xiaoping in the 1980s. 

It will subdue the entrepreneurial activity that has been so important in powering China’s dynamic private sector, with lasting consequences for the next, innovations-driven, phase of Chinese economic development. 

Without animal spirits, the case for indigenous innovation is in tatters.

With Evergrande blowing up in the aftermath of this sea change in Chinese policy, financial markets, understandably, have reacted sharply. 

The government has been quick to counter the backlash. 

Vice Premier Liu He, China’s leading architect of economic strategy and a truly outstanding macro thinker, was quick to reaffirm the government’s unwavering support for private enterprise. 

Capital markets regulators have likewise stressed further “opening up” via new connectivity initiatives between onshore and offshore markets. 

Other regulators have reaffirmed China’s steadfast intention to stay the course. 

Perhaps they doth protest too much?

Of course, on one level, who wouldn’t want common prosperity? 

US President Joe Biden’s $3.5 trillion “Build Back Better” agenda smacks of many of the same objectives. 

Tackling inequality and a social agenda at the same time is a big deal for any country. 

It is not only the subject of intense debate in Washington but also bears critically on China’s prospects.

The problem for China is that its new approach runs counter to the thrust of many of its most powerful economic trends of the past four decades: entrepreneurial activity, a thriving start-up culture, private-sector dynamism, and innovation. 

What I hear now from China is denial – siloed arguments that address each issue in isolation. 

Redistribution is discussed separately from the impact of new regulations. 

And there is also a siloed approach to defending regulatory actions themselves – case-by-case arguments for strengthening oversight of internet platform companies, reducing social anxiety among stressed-out young people, and ensuring data security.

As a macro practitioner, I was always taught to consider the combined effects of major developments. 

Evergrande will pass. 

Common prosperity is here to stay. 

A regulatory clampdown, in conjunction with a push to redistribute income and wealth, rewinds the movie of the Chinese miracle. 

By failing to connect the dots, China’s leaders risk a dangerous miscalculation.

Stephen S. Roach, a faculty member at Yale University and former chairman of Morgan Stanley Asia, is the author of Unbalanced: The Codependency of America and China.

Digital Currencies Pave Way for Deeply Negative Interest Rates

If people can’t hoard physical money, it becomes much easier to cut rates far below zero

By James Mackintosh

Investors have been ignoring progress toward government-issued electronic money, even as many countries are progressing rapidly toward their own online cash. 

They should ask two questions: Will the Federal Reserve issue a digital dollar? 

And will it eventually replace physical bank notes?

I think the answer to both questions is yes, and those who agree should be assessing the impact on future monetary policy already, because dramatic change is likely within the timespan of the 30-year Treasury.

The main monetary power of the digital dollar comes from the abolition of bank notes. 

If people can’t hoard physical money, it becomes much easier to cut interest rates far below zero; otherwise the zero rate on bank notes stuffed under the mattress looks attractive. 

And if interest rates can go far below zero, monetary policy is suddenly much more powerful and better suited to tackle deflation.

Before going on, a quick definition: I’m talking here about central bank-issued money usable by you and me, just as bank notes are. 

It might (or might not) pay interest, but it is different to money in an ordinary bank account, which is created by the commercial bank; the existing central-bank digital money, known as reserves, are used only to settle debts between banks and certain other institutions, not available for ordinary use.

Deeply negative rates won’t come straight away. 

Initially, central-bank digital currencies will almost certainly be designed to behave as much like ordinary bank notes as possible, to make their adoption easy and minimize disruption, while use of physical cash will be allowed to wither away. 

But those close to the development agree that monetary caution is unlikely to last.

“Central banks are making lots of effort to make sure that CBDC isn’t seen as a possible monetary-policy instrument,” says Benoît Coeuré, head of the Bank for International Settlements’ innovation hub and a former European Central Bank policy maker. 

“My take is that that discussion will come only later.”

This matters for investors, because if rates can be taken deeply negative it would shift the long-term outlook for interest rates and inflation. 

The ECB has a rate of -0.5%, the Bank of Japan -0.1% and the Swiss National Bank -0.75%. 

But none think they can go below -1%.

The main limit is that deeply negative rates would encourage people to switch to bank notes to “earn” zero on their savings, instead of losing money. 

There are costs to hoarding large amounts of physical money, including storage and insurance against fire or theft, which allows slightly negative rates. 

But go deep enough, and negative rates would be applied to an ever-shrinking pool of savings, undermining their efficacy and draining the banks.

The monetary impact of removing, or at least reducing, this effective lower bound, as economists call it, is profound. 

Instead of turning to new and still unproven tools like the bond-buying of quantitative easing, central banks would be able to keep cutting rates when a crisis hit. 

And they would cut a long way—the trillions of dollars of QE and other experimental policies were equivalent to a “shadow policy rate” for federal funds of minus 5% by 2011, according to BIS research.

The bank note alternative isn’t the only thing preventing central banks from taking rates to -5%.

“It isn’t natural,” Mr. Coeuré told me. 

“Negative rates aren’t easy to understand. 

There will be a reluctance both by central banks and financial institutions to go there [deeply negative].”

Resistance from politicians and the public would make policy makers cautious about such radical policies, and some central bankers already worry about the side effects from prolonged periods of negative rates. 

But as Mr. Coeuré, who oversaw bond-buying while at the ECB, could tell you, what once seemed to be an impossibly extreme monetary policy can quickly become the norm.

Accept that interest rates might be deeply negative in serious recessions, and there is still a puzzle: Does that make long bond yields lower, or higher?

The argument for lower yields is basic mathematics. 

A 30-year bond should yield the average of the fed-funds rate over the period, plus or minus a risk premium. 

Take away the lower bound on rates, and the occasional negative rate should mean a lower average, all else equal.

As usual in economics, though, all else isn’t equal. 

The aim of deeply negative rates would be to stimulate the economy, creating a quicker recovery and allowing the central bank to raise rates again more quickly than if it was stuck at the lower bound for years, as the Fed was from 2008 to 2015 (the longest period without a rate change since at least 1954).

If negative rates worked, it might not mean a lower average over time. 

Instead, it might mean higher average inflation, and similar or even higher rates, as the economy could quickly be jerked out of the rut of secular stagnation, and rates and inflation return to normal.

“It is hard to say which way it would go,” says Eswar Prasad, a professor of economics at Cornell University and author of a forthcoming book on digital currencies, “The Future of Money.” 

“At times of extreme peril, it could make a difference.”

Making a decision comes down to how you view monetary policy. 

If you think it doesn’t really work as stimulus anyway, then negative rates would provide little to no extra support; a Japanified economy with even more negative rates might just have lower bond yields, and still no inflation.

If you agree with the central banks that interest rates are a powerful tool for reflating the economy, then digital money removes the asymmetry that prevents rates being used to tackle deflation. 

That should remove much of the risk of persistent deflation, justifying higher long-term bond yields.

Either way, interest rates matter for bond yields, and electronic money can give central banks more freedom with interest rates. 

How long it takes is up for debate, but some countries have already moved beyond the experimental stage, and policy makers are feeling the pressure from crypto developers, especially so-called stablecoins tied to the value of ordinary currency. 

It is time for long-term investors to start paying attention.

Breaking Bad Bond Buying

It is understandable why a central bank would print money to purchase assets at the height of a financial crisis. But continuing such policies under conditions of relative tranquility makes little sense – and raises serious risks.

Andrés Velasco

LONDON – In the run-up to the Federal Reserve Bank of Kansas City’s annual symposium in Jackson Hole, Wyoming, last month, the discussion had focused on whether monetary policy should be tightened in response to higher US inflation. 

By suggesting that asset purchases would be tapered first, and that interest-rate increases would come much later, Fed Chair Jerome Powell has shifted the conversation to the question of how policy should be tightened.

While printing money to buy bonds and reduce long-term interest rates is justified during crises like those in 2008 or 2020, the case for maintaining quantitative easing (QE) in more tranquil times is far from obvious. 

To see why, it helps to dispel three misconceptions about QE.

The first misconception is that QE is a monetary policy. 

It is not. 

Or rather, it is not just that. 

It is also a fiscal policy. 

In every country, the central bank is owned by the treasury. 

When the Fed issues money – central bank reserves, in fact – to buy a government bond, the private sector is getting one government liability in exchange for another.

The second misconception is that the government (including the treasury and central bank) always comes out ahead from such a transaction, because the private sector is left holding a security that pays a lower rate of interest. 

That need not be so. 

Central bank reserves can be held only by commercial banks, which have limited use for them. 

To induce banks to hold more reserves, central bankers must pay interest on them, as the Fed and the Bank of England started doing in response to the 2008 financial crisis.

The third misconception is that whenever the interest rate on central bank reserves is zero or lower than the rate on government bonds, the government can spend what it pleases, when it pleases. 

This is the central tenet of so-called Modern Monetary Theory. 

It is pithy, spiffy, snazzy, and wrong.

Yes, financing from money creation (economists call it seigniorage) is feasible whenever the yield on money is below that of government bonds. 

But as the central bank prints more and more money, it must pay higher and higher interest rates on that money to ensure that commercial banks and the public will want to hold it. 

Sooner or later, the interest-rate gap closes and there is no more seigniorage to be had. 

If the central bank keeps printing money beyond this point, the private sector will begin dumping it, causing currency depreciation, inflation, or both.

Once one accepts these three provisos, one must ask the multi-trillion-dollar question: Does QE make sense, from a fiscal point of view, in the United States today? 

The answer is no, for at least two reasons.

In late August 2021, the Fed was paying 0.15% interest on commercial banks’ reserve balances at a time when the interest rate on short-maturity Treasury bills was oscillating around 0.04%. 

That means it is cheaper (for the US taxpayer) to finance expenditures by issuing bonds than by printing money.

This might seem paradoxical. 

But it is important to remember that yield is a proxy for liquidity. 

Reserves at the Fed can be held only by banks. 

They do not serve as collateral and are subject to capital requirements. 

Treasuries, by contrast, can be held by anyone. 

They are traded in a huge, deep market and are routinely used as collateral for other financial operations. 

No wonder investors view Treasuries as more liquid and demand a lower yield from them.

Debt maturity is the other reason why additional QE makes little fiscal sense. 

Treasury bonds come in many maturities, stretching out to 30 years. 

But the non-required portion of Fed reserves comes in only one maturity: instantaneous (since commercial banks are free to withdraw them at will). 

Hence, every time the Fed issues reserves to buy a long-term bond, it is lowering the average maturity of government-issued debt.

If the interest rates on long-term Treasury bonds were high, such a policy would be sound. 

But the rate on the oft-quoted ten-year Treasury today is substantially below the Fed’s targeted inflation rate for that period, which implies that people around the world are effectively paying for the privilege of handing their money to the US government for the next ten years.

Under these circumstances, as Lawrence H. Summers recently argued in the Washington Post, the right policy is to “term out” public debt – locking in the very low rates for as long as possible – not to “term in” the debt as the Fed is doing with QE. 

Here, a government is like a family looking to take out a mortgage: the lower long-term rates are, the more sense it makes to borrow long.

The homebuyer’s analogy also illuminates the other risk introduced by short maturities: exposure to future interest-rate hikes. 

In the US, where 30-year fixed-rate mortgages are common, a new homeowner need not worry about what the Fed will do with interest rates next year – or even in the next couple of decades. 

But in the United Kingdom, where floating-rate mortgages are the norm, homeowners are always fretting over what the Bank of England will do next.

In managing its debt, the US federal government has gone the way of British homeowners. 

Though interest rates will not rise tomorrow, they certainly will someday, and when that happens, rolling over huge stocks of debt at higher yields will have a non-trivial fiscal cost.

One can also imagine nasty financial dynamics at work: a rising interest burden causes more debt to be issued, and this increase in supply reduces the liquidity premium on the new bonds, further raising interest rates and requiring ever-larger bond issues.

Moreover, unsavory political dynamics could emerge. 

When the central bank’s decisions have a big impact on the public purse, politicians will be more tempted to cajole central bankers to keep rates low. 

Skeptics will counter that this kind of thing doesn’t happen in the US. 

But America’s previous president was not above browbeating the Fed via Twitter, which was not supposed to happen. (Presidents like Donald Trump were not supposed to happen, either.)

These are not arguments for a more contractionary monetary policy; the Fed can keep the short-term interest rate as low as needed. 

Nor are they arguments in favor of a more contractionary fiscal policy; if the Biden administration wants to spend more, it can issue long-term bonds or raise taxes. 

Printing money to pay for the deficit used to be the progressive thing to do. 

Not anymore.

Andrés Velasco, a former presidential candidate and finance minister of Chile, is Dean of the School of Public Policy at the London School of Economics and Political Science. He is the author of numerous books and papers on international economics and development, and has served on the faculty at Harvard, Columbia, and New York Universities.